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Wednesday, 22 October 2014

Road to recovery?

Detroit case revs up bankruptcy option for others

It’s the start of a new era for Detroit – and perhaps other American metropolises in wobbly financial condition. A federal bankruptcy judge ruled on Tuesday that Motown, suffocating under about $18.5 billion in debt, was eligible to file for protection from creditors. If the decision withstands appeal, it would confirm bankruptcy as a credible option for even the biggest U.S. cities. It could also give other municipalities the needed kick to get their houses in order.

A formal plan for reorganizing the city’s finances may come before the end of January. If it looks anything like an initial proposal offered by Detroit’s emergency manager in June, city retirees, bondholders and insurers will share the pain of financial restructuring. Freeing up cash to fund the police and other basic services should give the city, which has lost more than half its population since 1950, a fighting chance at survival.

Detroit’s shocking population losses and the near-evaporation of its tax base make it an extreme case. But its ordeal has important implications for other cities, as well as investors.

Motown’s initial proposal for dealing with creditors lumped holders of general obligation (GO) bonds with unsecured creditors, including pensioners. GO bonds are considered almost sacrosanct, because they’re backed by a government’s pledge to use its taxing power to pay them in full. Unsecured debt, on the other hand, usually takes a big hit in bankruptcy.

If the city sticks with that plan, yields on GO bonds will probably rise. What’s more, profligate city councils will no longer be able to get away with vague promises to raise money through tax increases and may be forced into more financial discipline.

Meanwhile, cities where bankruptcy is an option may start to drive harder bargains with unions. The judge in the Detroit case stressed that pension cuts are on the table, despite arguments that Michigan’s Constitution makes them untouchable. It may take the Supreme Court to resolve the issue, but a more credible threat of pension cuts should give cash-strapped city governments extra leverage.

Even with the help of bankruptcy, Motown faces a long struggle to right itself. But there’s some consolation in the possibility that today’s ruling will help other cities avoid its fate.

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Detroit was cleared to file for Chapter 9 bankruptcy protection on Dec. 3 after a federal judge ruled that the cash-strapped city had too many creditors to make negotiations aimed at avoiding insolvency practical.

The ruling, which makes Detroit the biggest U.S. city ever to be declared insolvent, came 25 days after the end of an eligibility trial in which labor unions and other creditors argued against the city’s bankruptcy petition.

A formal plan of financial readjustment is expected by March 1. A restructuring proposal published by Detroit’s emergency manager in June called for steep cuts in payments to city worker pensions and some bondholders.

The American Federation of State, County and Municipal Employees, a U.S. labor union, has filed a notice of appeal to the U.S. Court of Appeals.

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